Why Another (Imminent) Financial Crisis Is a Good Thing

Includes: KBE, KRE, XLF
by: Bo Peng

This PBS Frontline program on Brooksley Born, the former head of CFTC during Greenspan's godhood, and her one-woman fight on regulating OTC derivatives is a must-watch for everyone with a passing interest in the 2008 crisis. I only wish I didn't miss it in 10/2009 when it was first aired.

The program made it abundantly clear that the LTCM crisis was completely wasted. It's also beyond doubt that, in retrospect, most of the Great Depression had been wasted by the time Glass-Steagall was abandoned. And many say the 2008 crisis has been wasted already.

I fully agree with this conclusion, but have a somewhat different perspective. The real failure in our society lies in the fact that none of the fundamental, structural deficiencies exposed by the crisis has been addressed.

  • Over-sized financial sector. As of 2007, the financial sector in the US accounted for 8% of GDP and 40% of corporate profit. This is a bigger issue than TBTF institutions, which is not addressed meaningfully in the financial reform bill. ECB Executive Board member Lorenzo Bini Smaghi discussed this specific topic very well in 4/2010. But none of US politicians/regulators would touch this.
  • Systemic correlation risk. Today's world is so interconnected, especially through the over-sized financial sector, that most swans have turned black. The global financial system has become an extremely unstable chaos system in which a small disturbance may get amplified through the intractable web of over-sized financial transactions and manifest into a major disaster. Yet institutional risk management is still VAR-based, although it has been amply proven inadequate against tail risk. As long as this systemic instability is not addressed, we will have more financial crisis. Increased bank capital requirement only pushes the breaking point a bit further out, with no effect in preventing financial chain reaction. Clearinghouse similar.

The only hope is yet another, even bigger crisis. And it'd better come soon, before the political momentum is completely lost and would have to start from 0 again.

Fortunately, we already have one brewing right under our collective nose: eurozone sovereign insolvency + bank insolvency + US deflation + China slowdown = oppportunity for structural overhaul.

  • Eurozone. Sovereign insolvency may be delayed for awhile, if the bailout package gets implemented, which is far from certain. But European banks still face huge difficulty on many fronts: bad asset from lingering housing crisis, deteriorating economic outlook due to austerity measures, high funding cost, and high leverage. Again through the financial chaos system, US banks will be among the first victims of a European banking crisis.
  • US lost decade. Faced with the huge overhang of real estate default pipeline and unemployment, US recovery will at best be a square-root. Further Fed QE will have diminishing marginal effect. But I think US will face a deflationary lost decade like Japan, but for a somewhat different set of reasons. I'll write more about this later.
  • China can at best save itself. Because of over-reaction in monetary easing and stimulating domestic demand at the height of 2008 crisis, China now faces great pressure of inflation and asset bubbles, which is made much trickier to deal with by the pending US/Europe deflation. When it happens, China will try to create demand domestically and in emerging markets. They'd be lucky to find enough demand to keep its own economic machine churning. It's impossible for China to pick up any demand slack for US/Europe; the market is simply not big/mature enough yet.

I don't know when it'll materialize. I just know that some unforeseeable, seemingly trivial event could trigger it -- a classic butterfly effect. And such seemingly random, disparate, trivial events will keep on happening until a systemic collapse is triggered.

Welcome to the era of financial system chaos.

Disclosure: No positions

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